Tail events - Historical, Implied and Subjective Distributions

Macro tail events actually occur more often than what you may think. There will be a big negative shock every 2-3 years. We have had the luxury of an extended period of calm before the 2020 pandemic and March liquidity crisis. Unfortunately, the result of less frequent tail events is complacency.

We have discussed the tale of the tail and how to form expectations for tail events, but there are also some market information and indices that can help with measuring the increased likelihood of tail events.

Clearly, there is historical volatility that can provide scale for tail events. An increase in volatility will increase the likelihood of a tail event. The current volatility can be compared with the past as well as current  forward-looking expectations of volatility in implied values. 

Subjective expectations can be overlaid upon these historical and implied volatilities. We focus on three categories: policy uncertainty embedded in the news, surprise data, and financial stress and risk aversion indices. Higher policy uncertainty can lead to policy surprises.  Deviations in forecast will lead to trends and potential extremes as reality and expectations converge.  More financial stress will lead to greater negative market reactions. Theses indices may not forecast a specific event but may indicate an environment more sensitive to extremes. These indicators may help sway expectations of a tail event versus market expectations.